Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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Entrepreneurs may often be under the wrong impression that their business debt will disappear when the business is sold. In some cases, the debt is absorbed or is assumed by the buyer. But usually this is not the case.
Knowing what happens to business debt when selling a business is a critical part of the exit planning process and in determining which buyer is making the best offer.
The pandemic introduced PPP Loans, which may not be forgiven by the SBA, further complicate things. The SBA issued a Procedural Notice to address how to handle an outstanding PPP Loan when selling a business.
Furthermore, understanding how the debt on the company’s books ultimately affects the purchase price paid by a buyer or investors is important. And regardless of how the business is transferred, it’s important to understand how debt on the company’s books influences the price paid by the buyer or group of investors.
Stock vs. Asset Sale
While larger businesses and those sold in the public markets are typically sold under a Stock Purchase Agreement, such transactions can occur in the lower-middle and middle market. Stock sales are consummated with the transfer of the common and/or preferred shares of stock to a new owner. When this occurs, the buyer or investor is responsible for all debt and liabilities recorded on the books, as well as any undisclosed liabilities which may be present. Because of this, many small businesses are not sold under a ‘stock sale’ arrangement.
Asset sale arrangements between a business owner and a buyer involve the transfer of title to certain assets and in some cases certain liabilities. The combination of assets and liabilities transferred in an ‘asset sale’ is varied and subject to negotiation.
For example, in an asset sale a buyer may purchase the Inventory and one half of the Accounts Receivable while assuming all of the Trade Accounts Payable. The seller may retain one half of the Accounts Receivable and the Line of Credit. Any combination of Assets and Liabilities may be transferred to a buyer and/or retained by the seller in an asset sale transaction. A better term for an asset sale may be a non-stock sale.
As you can imagine, every buyer wants to acquire different assets and may be agreeable to assume certain forms of debt or liabilities, so comparing multiple offers in an apples-to-apples fashion can be challenging.
To further complicate the comparison process, each asset being transferred holds a different tax basis which affects the net amount of cash the seller receives after filing his federal and state tax returns. Don’t try this at home!
Enterprise Value
When public companies are compared in acquisitions, sophisticated Investors use a financial measurement called Enterprise Value to compare companies with different capital or debt structures.
Enterprise Value is a measurement of how much it takes to buy the entire company, not just the stock or equity. A company may sell its shares of common and preferred stock to investors for a sum of ‘X”, and at the same time assume the debt or liabilities equal to ‘Y’ and enjoy the cash on its balance sheet equal to ‘Z’.
Enterprise Value considers all three factors: Stock Price (X); plus the debt or liabilities on the books (Y); less the cash on the books (Z). EV = X + Y – Z.
Enterprise Value is a more accurate measurement of a company’s value because it includes the debt that the business must pay to its creditors and also accounts for the offsetting cash on its books.
Debt Counts No Matter What the Size or Kind of Business Sale
Business buyers, who understand capital structure and how a company’s debt negatively impacts its value, incorporate debt into the amount they offer to the seller. This is true whether the transaction is a stock or an asset sale.
If it is a stock sale, the buyer has added the amount of debt owed and subtracted the cash on the books to compute the company’s value.
If it is an asset sale, the debt is accounted for.
However, it is not a straightforward computation and the debt’s impact on the cash they ultimately receive from the sale is not always obvious to the seller.
When selling a business, the entrepreneur will be well-served if he seeks advisors who are able to provide apple-to-apple comparisons while accounting for debt and other liabilities. Although the computations needed to do so are not as simple as calculating the Enterprise Value of a public company, the principle is the same.
I sold my 19% of a LLC to my two business partners on July 31st 2015. At the time we had a loss of $86,000 YTD. I just received my K1 and it shows a 9.4% ownership for and a loss of $56,000 for the full fiscal year. The accountant said he used the “weighted average method” to come up with this. This only allows me to write off $5,264 in losses as opposed to $16,340. Is this correct? Since I was out of the business in June, should I be held accountable for the financials (good or bad) for the rest of the year?
Hi John,
Well the general rule for partial year S Corp shareholders is to allocate the total income/loss for the year on a pro-rata, per share, per day basis. This would mean the total loss for the entire tax year in the amount of $56,000 would be allocated by day in the amount of $153.42. If you owned the company from January 1st to July 31st, that would be 212/365 days or 58.09% of the entire year. Given your 19% ownership for the partial year, the computation would be 212 days multiplied by $153.42 daily net loss, multiplied by 19% for a total reported loss for you in the amount of $6,179.76.
Shareholders may by unanimous consent agree to cutoff the income/loss for the year at the point in time when a shareholder either sells (or alternatively buys in). This would have resulted in a larger loss for you: $86,000 multiplied by 19% or $16,340.
I may not have the amount of the loss or the dates quite right so this may explain the difference between what’s shown on your K-1. If not, you may want to revisit the calculation with the Accountant.
Hello Holly – My Wife was a partner in an S Corp – business did not do well so she sold her share to her partner for $1.00. I believe it was just her equity. At the time we had a cost basis of let’s say $30K. I believe at the time (this is several years ago) we allocated $15K of the loss as equity – which we have been deducting $3K a year on our taxes as a loss, and we allocated the other $15K to debt that we’d figured we’d eventually write off when the business went out of business. Anyway I found out that the business was sold last year (for not much I’m sure – the equipment was the only assets are old). So my question is how do I go about writing off the debt as bad? what proof do I need to show the IRS? Thanks!
Hi Andy,
I am going to answer your question. Before I do, there is background information I need to share with you before you consider writing off a bad debt from your wife’s former business.
In order to write off loan from a shareholder as bad debt, a number of conditions must be met. First and foremost, at the time the loan was made to the business the loan needed to be properly documented. Shareholder’s loans to the business would need to be represented by a formal, written note. The note should bear a fair rate of interest and should have been recorded as authorized by the officers of the corporation in the annual corporate minutes.
If this was not done, taking a bad debt deduction is not possible. Essentially, your wife’s $15,000 balance would be considered equity and subject to the $3,000 /year limit on capital losses.
If the proper documentation was in place, there are several other circumstances, such as whether the business was able to pay back the shareholder loan when the agreement was made, which need to be considered as well in order to write off a bad debt. Unfortunately, there are many hoops to jump through in or to establish your position that a valid debt existed if you desire to write it off as a bad debt.
That said, if the business has been sold to a new owner and you have a valid debt with the corporation, you should consider presenting your debt to the new owners for payment. If they bought the corporation’s stock, you have a valid debt claim against the corporation. If on the other hand, the business was sold under an asset sale then you may have a claim against the former shareholder (your wife’s business partner) since the debt was not paid from the proceeds from the sale.
Okay, if all of the documentation was put in place properly at the time of the loan and either the new owner or former owner refuses to pay the loan back, request a written statement indicating the debt will not be paid back and keep it in your tax files. You shouldn’t need to include the written statement with your tax return, however I’d keep the document handy in case the IRS asks for proof in the future.
I hope this helps Andy and wish you and your wife all the best…
Hello,
My mother inherited 50 percent partnership with one other partner when my father passed away 7 years ago. She has never had anything to do with the rental property that it holds. She actually kind of forgot about it. There have never been any profits distributed or any requests for cash injections. The property has no value to her and she would like to have the partnership wound up, preferably without a trial.
The partner does not want to dissolve the partnership.
We have been to court to ask for help with the deadlock.
Now the partner is claiming unpaid bills due him that effect the “outside capital account”. Is it possible for him to put her in a situation where he gets any proceeds and she end up with debt?
Thanks, ~Chelsey
Hi Chelsey,
I am sorry for your troubles and appreciate the stress this may cause you and your mother.
It’s very difficult to answer your question because there are many facts unknown to me. And they are likely unknown to you and your mother, given the situation.
Here is what I’d consider asking the other partner about:
“Please provide us with all of the Federal Form 1065 K-1s since my father’s death.”
Why? If your mother is a 1/2 partner, she should have been receiving Federal Forms 1065 K-1s to account for her pro-rata share of the rental properties income (or losses) over the past seven years. This form would help you and your advisors understand what type of partnership it is, whether she is a limited or general partner and what the capital account balance is at this time. All of this information is important to resolve your mother’s situation.
“Please provide us with the Partnership Agreement.”
Why? This written agreement spells out what your late-father and the partner agreed upon before he passed away. Again, it’s important and relevant to your current situation.
All the best to you and your mother Chelsey…
We do have 1065 forms. The partnership is a general partnership. There have only been losses as far as I can tell. The capital account is unbalanced in my mother’s favor.
Her partner’s attorney was “mysterious” about the “outside basis” when speaking with her attorney after a court hearing (asking for the partnership records). Her partner has had sole control of the entire partnership.
I am concerned that he could arrange their situation in such a way that leaves my mother with either nothing or debt.
Hi Chelsey,
If the partnership is a GENERAL Partnership, all partners are considered to be general partners. This means each partner may be held personally responsible for the debts of the general partnership.
So, knowing if the partnership is a General Partnership as opposed to a Limited Partnership is very important in your case.
A Limited Partnership designates one person (or entity) to serve as the General Partner while the remaining partners have a limited partner role. The limited partners enjoy limited financial liability to the extent of their capital account and do not manage the business. The General Partner in a Limited Partnership calls the shots and has unlimited financial liability exposure.
It sounds as if in practice you mother’s role has been similar to a limited partner. I don’t think that matters if the business entity is a General Partnership. That’s really a good question for an Attorney.
You initially referred to the reason for your father’s former partner requesting “money for unclaimed bills due him that affect the outside capital account”. I don’t know what that is. I’ve never heard of the term “outside capital account” before.
You also mentioned the term “outside basis”. Outside basis is the tax basis the partners have in the general partnership.
When a partner contributes assets to a partnership (let’s use land as an example), the fair market value of the land is what’s recorded on the partnership’s books. That value is the “inside basis”. This amount may be different than what the partner actually paid for the land. If the land was purchased for $40,000 and subsequently contributed to the partnership when it was worth $240,000, the inside basis would be $240,000 and the outside basis would be $40,000. Taking this example a step further, if the partnership wound down its business and distributed $440,000 to this partner with an outside basis of $40,000., then the partner would have to pay income tax on the difference of $400,000. It’s the outside basis which matters when a partnership winds down.
There shouldn’t be anything mysterious about the outside basis for your mother. It has nothing to do with the partnership. The partnership tracks the inside basis not the outside basis.
So push back. Ask for something in writing. Demand to see the books. Your mother’s a general partner and so it goes. If she has the responsibility for everything, she also has the right to see everything.
All the best…
Last year my partner bought me out of the business in April (an S corp if that is relevant) as she wanted to keep it going for as long as possible. A few months later she decided to close the business and sell off all the remaining assets, none of which I was involved in. Today she is asking for me to assist in paying the business taxes and accountant expenses for the 3.5 months that I was still affiliated. I am under the impression that by being bought out, I am relinquished of any further costs associated as there was no agreement that I would pay the tax at the time of the buy out.
Any insight is appreciated.
Hi Abby,
The fact that the business was a S Corporation for federal tax purposes is relevant.
Generally income of an S corporation must be allocated among the shareholders pro-rata on a per-share, per-day basis. So when a shareholder sells his or her shares, a portion of the business income (or losses) in the year of sale end up being reported to the selling shareholder.
It is possible for Shareholders in an S Corporation to elect to cut the year into two parts so the selling shareholders are paying taxes on their pro-rata share of income through the date of sale. Any income (or losses) which occur after the date of sale in such a scenario would be allocated to the remaining shareholders. This scenario requires the books to be closed for the short period.
In either case, you should receive a form k-1 from the S Corporation which would indicate the amount of income taxable to you individually.
I hope this is helpful Abby!
All the best…
We are a small LLC operating as a Corporation (Not an S but a C). My father passed away and my mother inherited the entire 100% of the Stock. After 6 months of trying to deal with the problems associated with a small business, she wants out. We are going to sell the stock out right to her son who operates the business. However, there is an unsecured “loans from Stockholder” that has accumulated over the last 40 years where my father would put money into the company not expecting a return. (This company was his by intelligent design). However, the bank will NOT loan my brother the money to buy out my mother because of this loan. We have been getting conflicting advise, come to find out, it is for a partnership or a S corp. None of those apply here. I want to “forgive” the entire debt. Is that even legal?
Good morning Elizabeth,
My sympathy to you for the loss of your father. I am sure this has been stressful for your entire family, given the situation.
The Loan From Stockholder balance represents money your late father lent to his business. For tax purposes, your mother’s LLC (she has inherited) is being treated as a C Corporation.
At this time, essentially the C Corporation has a loan owed to your late father’s estate. Your late father’s estate should be recognizing a loan (or note) receivable as one of the estate’s assets for inheritance/estate tax purposes. This may or may not be significant, depending on the size of the loan and the size of your late father’s estate as well as the State in which he resided when he passed away.
Loan forgiveness for pass-through business entities, such as an S Corporation or Partnership, is treated differently than when the business is treated for tax purposes as a C Corporation. The reason for the difference in loan forgiveness treatment is due to the fact that loans made by shareholders in a pass-through business entity affect the shareholder’s tax basis. This is not the case for C Corporations.
Generally speaking, the Executor/Executrix may chose to forgive the debt. That said, most debt forgiveness results in a Cancellation of Debt Income to the holder, in this case the holder would be the LLC (C Corporation). And the treatment of the COD Income to the C Corporation will depend on whether the business is solvent or not.
I recommend you discuss the situation with your late-father’s estate Attorney to determine the best course of action.
I hope this sheds some light on your situation!
All the best…
Thank you, it does. I wish his estate attorney had taken care of this before my father’s passing. But it is what it is. Your advice was very helpful.
Yes, it is what it is indeed Elizabeth.
Again, my condolences and all the best to you as you work through the matters settling you father’s estate and resolving the family business ownership issues.
We have a 4 way ownership into an LLC. One partner is selling their share. We each pay monthly dues into the LLC. The partner selling owes the other partners a debt but refuses to pay. What happens to his share of dues that was collected when he sells? Does it transfer to new owner or can the other partners collect on some of their lost money or does it go with the seller?
Good morning Tammie,
If you did not elect to treat your LLC as a C or S corporation when it was initially formed, by default your LLC is treated as a partnership for tax purposes. This is important to understand in the context of your question.
I am not familiar with an LLC where its members pay dues to the LLC each month. Maybe you and the other members are required by the LLC’s Operating Agreement to contribute cash to the LLC to cover a cash shortfall if necessary? This situation is not unusual.
If the LLC is being treated for tax purposes as a partnership, then the cash contributed (what you are calling member dues) should have been recorded on the books as an increase to the members’ capital accounts. The pro-rata share of the LLC’s income and expenses also flow through the individual members’ capital accounts as well.
If the selling partner has not made all of the contributions to the LLC, his or her capital account should be less than the other members if they’ve all made their contributions. The balance in the selling member’s account is their tax basis, so the “dues that were collected” are accounted for.
You haven’t defined in your question who is buying the member’s share in the LLC so it’s difficult to take my answer to your question much further.
If you’d like to share more, I will give it my best shot to help you.
All the best to you and your other LLC members Tammie…
Hi Holly
According to my credit report I owe a company money
I called the company, but the new ownership says
“I have never done business with you, you don’t owe me a dime”
1. how do I clear it off my credit
2. Does the old owner still have the right to collect?
Theory –
a. When you sell you sell all profit and loss
b. You would take a tax write off if it happened a year or two ago
c. Can you the old owner get paid twice / benefit twice for the same debt?
Hi Tom,
I am having difficulty following your questions.
Did you sell your business and did the new owner of that business assume business debt?
1. I had a debt with another firm
2. Then – That firm sold to a new owner
3. I called the new owner – he says I don’t owe him a dime
3. I called the collection agency who has the old debt
4. They gave the debt to a lawyer
Basically my question is –
a. When the firm sold – did the debt and earnings transfer?
b. How do I get rid of a debt from my credit when the new owner says I don’t owe him a dime?
Good morning Tom,
It’s worth reviewing how debt is handled when a business is sold to a new owner in order to answer your question.
If a business entity (corporation or LLC) is sold outright under a ‘Stock Sale” method — the buyer acquires the equity in the business in the form of stock or member’s equity. When this happens, any debt owed to or by the business sold stays with the business. If the business in question was sold under this method of transfer, the debt owed the business would remain on the books of the business until the new business owner either collects the money owed, turns it over to a collection agency or writes it off as a bad debt.
If a business is sold under an ‘Asset Sale’ method, which is most common with small businesses, the seller and buyer make an agreement to transfer specific assets and liabilities. If the business in question was sold under this method of transfer, the debt you owed the business may or may not have been transferred in the sale.
If your debt owed to the business was not transferred under an Asset Purchase Agreement to the new owner, the debt may still be collectible by the former owner of the business or the business entity if it has not been dissolved.
It is not clear whether the business you owed money to was sold to the new owner under the Stock Sale or Asset Sale method. Given your conversation with the new owner, it is implied they didn’t acquire your Account or Note Receivable. You should confirm this is the case.
If the new owner did not acquire your Account or Note Receivable, then it would be the former owner who is attempting to collect the money owed to him/her or their business. They may have continued rights to collect this debt from you.
First step to resolve the matter would be to confirm exactly who the party is attempting to collect the debt. Is it the former owner, the former business or is it the ongoing business?
I hope this is helpful…
All the best Tom…
Hello, I am leaving a company and turning over all my rights of ownership. As part of the deal about $350K in loans on company books is being absorbed by the company and I will assume the loans which will in turn, become equity in another company for me. The question I have is, what language would totally absolve me of tax issues. Company forgives loans or is it even possible to avoid the issue?
Hi Alex,
I am not really certain I understand what you’ve agreed to do with regard to your ownership stake in company number one and which company is assuming the $350K loan — company number one or a new business.
Could you clarify?
Also, what type of tax issues are you concerned about?
Hello,
I am leaving Company A (an LLC, incorporated in Delaware,) where the $350K in loans currently lives on its books. As part of my payout/severance (not sure what to call it, could also be looked at as selling my interests in Company A, also an LLC inc in California) Company A will ‘forgive’ the loans on its books. Those loans were given to Company B, and now they will transfer into equity for Company B, which I will be running. Will this look like Capital Gains, or can Company A put this as a loss on their books, or? The last thing I would want is to pay taxes on this money. Let me know if that clarifies. Thanks
Hi Alex,
I am going to make an assumption that Company A previously made a loan to you as either its shareholder, member or partner. My answer is based on that assumption.
When a shareholder in a corporation, member of an LLC, or a partner of a partnership borrows money from the business, a Loan Receivable is recorded on the books. If the owner’s debt owed to the business is forgiven, then the tax treatment depends on which type of business entity it is.
If it’s an S Corporation, the forgiveness of a shareholder loan is treated as either ordinary income or if re-characterized as a distribution, then as a capital gain if the Shareholder does not have sufficient tax basis.
If it’s a C Corporation, then the loan forgiven is treated as a constructive dividend to the C Corporation Shareholder.
If its an LLC or Partnership, the loan forgiven is treated as a reduction to the member or partner’s capital account and it will be taxed if the member or partner doesn’t have sufficient tax basis.
You may be participating in a Redemption of Stock arrangement which requires you to consider many factors before determining the potential tax consequences.
You should consult with your personal CPA in order to determine the tax consequences for your specific situation before making an agreement with your business co-owners.
All the best Alex…
Hi Holly!
A family member began buying into an LLC partnership a few years ago, only recently discovering that prior to her joining the other members had taken out a credit line for the business. They tell her that part of her buy-in includes paying for that debt. Currently, the partners are in the process of selling their business to an outside buyer that will be assuming their assets among other things. The partners agreed that each of their portion from the purchase of the assets/etc. would go to paying off the credit line. Are they correct in saying that she would have to continue paying into “her portion of the debt” and buying into a partnership that no longer exists?
Hi Elizabeth,
I am having trouble following the scenario and really don’t have enough information to specifically address your situation.
Although I can offer you a couple of facts about partnerships that may be helpful to you.
You mention both an LLC and Partnership. They are not the same animal! An LLC may be treated for tax purposes as a partnership. In fact, this is quite common.
LLCs have Operating Agreements for its members. Partnerships have Partnership Agreements for its partners. When your family member bought into either the LLC or Partnership, she should have been given a copy of either the Operating or Partnership Agreement. This document is what your family member needs to refer to in order to understand what her responsibilities are with regard to the business line of credit.
Hopefully this is helpful to you and your family member Elizabeth! All the best…
Company entered into a Share Purchase and Asset Sale Agreement (the “SPA”) with a shell company organized back in 2001. Change of name of the Company and domicile was approved by board of directors in 2015. in efforts to access liquidity through various financial products such as Equipment Sale Leaseback and so forth, the banks are having difficulties recognizing the time in business to be a few months contrary to what 10k, 10q or 8k reports on Edgar files display to which seems obvious to me that the history dating back to 2001 would stand as current time in business. i would like to know if you agree and if so how to go about helping financial institutions understand this.
Hi John,
If the business entity was organized in 2001 and since that time it was operating, the name change in 2015 should be traceable through your state’s corporation office. The trail is there and it may mean you have to produce the records at the state level to demonstrate what happened.
Additionally, you have bank statements and tax returns which would substantiate the 14 year existence.
Hope this helps you!
All the best John…